How to identify and mitigate the risks of DeFi?

By April 9, 2022April 28th, 20228 minute read
How to identify and mitigate the risks of DeFi?
Note: This blog is written by an external blogger. The views and opinions expressed within this post belong solely to the author.

The DeFi industry has only been around for a few years now. Despite this, there has been a tremendous amount of progress in decentralized economic models and technology in that short span of time.

Experimenting with free tokens in the DeFi realm via testnets carries no material risk. However, if you decide to buy and sell actual digital assets, you must be aware of the technical risks you might encounter.

When looking at DeFi’s potential, it is vital to consider the risks as well. Knowledge of DeFi risks can provide a real advantage in the efficient use of these technologies for various fintech goals. You will learn about the many types of risk and how to assess them in this article. Of course, not every DeFi risk is covered here, but it may be used as a starting point to think about some of the more significant DeFi investment hazards.

Risks in DeFi

The three major forms of risks of DeFi are financial risk, procedural risk, and technological risk. Financial risk pertains to possible rewards of investment opportunities and management of the opportunities. Financial risk is frequently linked to an organization or an individual’s risk tolerance. In addition, the level of financial risk a person faces is determined by their goals for managing a successful investment portfolio.

Hardware and software difficulties with DeFi devices and services are the most significant sources of technical risk. Using DeFi goods or services in a way that compromises security is an example of a procedural risk. Procedural risks are nearly identical to technical risks, except that they are associated with end-users rather than developers.

Technical risks

Technical risks in DeFi generally emerge from the difficulties with protocols, hardware, and software. The issue of technological risks is significant since they might affect the operation of the overall platform. Technical risks might depend on different aspects such as race conditions, API, use cases and exception handling, I/O processing, and memory safety. For example, due to race conditions, it’s often impossible to get to a sequence that determines the outcome of an event.

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Memory interruptions, access issues, uninitialized variables, and memory risks are all examples of memory safety risks. The user’s experience might be affected by a lack of use case and exception handling testing. To a similar extent, APIs that have not been thoroughly tested and evaluated are similarly unable to perform as intended. The absence of adequate testing leaves inputs and outputs open to technical risks as a result of I/O handling between devices.

DeFi Smart Contract, Hardware, and Software Risks

The technological risks associated with DeFi are likewise dependent on smart contracts, software, and hardware. Smart contract risks are significant for DeFi due to smart contracts’ significance in enabling automation. Smart contracts also expose multiple vulnerabilities leading to technical risks for DeFi.

Timestamp reliance, front-running, insufficient gas griefing, integer underflow and overflow, and coercive delivery of ether to a contract are all possible risks associated with smart contracts. There is a front-running risk that hackers will make use of the transactions mempool so that they can modify an unincluded block as they see fit.

There is a risk of integer overflow and underflow if the code cannot limit the value of the unit variable to 2256. If it happens, then the value is instantly reset to zero. When attempting to alter a block’s timestamp, miners run the risk of becoming dependent on that timestamp. In the forceful delivery of ether to a contract, the smart contract is subject to self-destruction. Insufficient gas griefing risks associated with smart contracts represent the initiation of transactions without concentrating on transaction sub-call.

Hardware risks are also significant technical risks in DeFi, particularly when hardware serves as the foundation for infrastructure that supports decentralized services. The common hardware risks associated with DeFi systems include sensitivity, power constraints, and incompatibility.

Voltage variations put the service’s life and performance at risk, while power risks might cause consistency difficulties for the service or application. Sensitivity risks in hardware originate from deterioration, humidity, dust, or other comparable factors. Hardware incompatibilities can lead to slowdowns and other problems as a result of the usage of certain hardware drivers.

When it comes to DeFi, software risks are also critical technological risks. DDoS assaults, injection, uncontrolled format strings, and overflow are all potential risks to DeFi software. DDoS is a genuine mention among strategies for interrupting of the regular operation of an app or service.

Injection risks indicate the possibility of harmful code being introduced into DeFi software via one of the most prevalent injection risks, SQL injection for web applications. Uncontrolled format strings are form-dependent and can be used to run malicious code in a web application. Overflow risks in DeFi software manifest themselves through the omission of specific software functions or their improper implementation.

Financial Risks Related to DeFi

Financial risks are an essential consideration in DeFi’s risk analysis. The financial risks in DeFi give insights on better utilization of DeFi platforms and services. Developers could, for example, concentrate on doing the right thing and decreasing the financial risks for clients through the provision of accurate advice and execution of improvements in their DeFi application.

Financial risk refers to the risk of losing money, and each user is accountable for comprehending financial risk based on their perception of their reward and risk appetites. As an alternative, a corporation will balance money management based on activities in order to reduce financial risk.

Additionally, financial risks are associated with the administration and distribution of funds across several systems and solutions in the case of governments. Due to DeFi’s universality, it is a viable contender for all of the above domains while assuring adequate value improvements. Because of this, traders and innovators in the DeFi market should employ techniques like technical and fundamental analysis to better manage risk.

The fundamental analysis aids in analyzing the value proposition of various assets using different measures and ratios. As a consequence, fundamental analysis reveals company value alongside the level of financial health. The technical analysis extends the fundamental analysis by utilizing mathematical indicators, charts, and patterns to help investors comprehend the risks associated with a particular investment.

Procedural Risks in DeFi

The fourth risk category is procedural risks. Interestingly enough, procedural risks emphasize the many security risks that DeFi products and services pose to users. The most prevalent security risks in DeFi are phishing attacks in which a malicious agent replicates a website or service to trick unwary users into providing their personal information.

Phishing attacks are also performed via emails in which users are sent out an email matching that of service providers. As soon as the consumer clicks on the email, they are sent to a fraudulent website. However, phishing emails can launch malicious code in the victim’s browser and install keyloggers.

The hacker might then leverage sensitive information for moving funds or perform unlawful operations without the knowledge of the user. Phishing efforts by hackers posing as representatives of a concerned DeFi provider are common in the cryptocurrency sector.

Other prominent procedural hacks should be taken into account while assessing procedural risks in DeFi. Some of these risks include baiting, pretexting, SIM switching, spearfishing, quid pro quo, and tailgating. Users may be tricked into disclosing personal information by someone pretending to be an official from the DeFi service. Baiting risks occur with ‘bait and switch’ approaches for infection of a web page.

Spear phishing is a form of social engineering that targets specific employees of a company in order to infiltrate its computer network and launch an attack. Spear phishing entails acquiring system access to any individual to manage the main system functionality and data. Quid Pro Quo risks are relatively identical to baiting; however, the difference of hackers giving big incentives for persuading victims to operate according to their wants stands out.

SIM-swapping is a prominent procedural risk observed with DeFi, notably owing to the usage of personal information of users for the construction of new SIM from concerned mobile service providers. In order to perform illicit operations on behalf of the user, hackers might utilize a fake SIM card. Tailgating is a significant risk in DeFi when it comes to gaining access to real-world locations through the manipulation of a person in a superior position.

The Best Ways to Manage the Risks of DeFi

Because of the numerous risks presented by DeFi, it’s clear that safeguarding digital assets is a necessity. The recommendations and best practices to minimize DeFi risks can offer significant security and protection implications. Now, let’s take a look at a few key tips for managing DeFi’s inherent risk exposures.

  • Invest in Products and Services You Can Rely On

Using reputable DeFi devices and services is the best way to avoid any problems. Before making a purchase, prospective DeFi consumers should read reviews and recommendations about the item or service in question. Take a step back if you have any doubts about the reliability of a certain DeFi product or service.

  • Make the Most of Multi-Factor Authentication’s Potential

Security may be greatly improved by using multi-factor authentication with a variety of trustworthy verification methods. Email confirmation, two-factor authentication, and multi-signature authentication, for example, have all been shown to reduce the risk of DeFi.

  • Don’t Ever Show Off Your Digital Assets

To avoid being targeted by hackers, users should avoid revealing any information about their digital assets. As with other high-end personal data, keep your digital assets discreet, and you will be able to avoid the hazards.

  • Security for Digital Assets

Many risks in DeFi might be eliminated if the security of digital assets is improved. Digital assets may be safeguarded by storing them in both hot and cold storage. Active use of DeFi services is well-suited to hot storage as a wallet solution. Cold storage, on the other hand, allows for the offline storage of digital assets in order to keep hostile agents at bay.

  • Importance of Updates and Backups

DeFi risks can be reduced by performing regular backups and upgrades. DeFi systems are often patched and updated by developers to keep them more secure. As a result, regular updates to DeFi software can reduce the chance of new vulnerabilities being discovered. In addition, digital assets can be more easily accessible if they are backed up on a separate drive.

Closing thoughts

On a concluding note, it is obvious that knowledge of the DeFi risks paves the way for solving them. To assume that there are no risks associated with DeFi would be irrational for anyone in the sector. Acknowledging and managing risk with DeFi sets the way for widespread use of the platform’s goods and services.

DeFi has the potential to become a standard way to obtain financial services in the long term. As a result, investors, businesses, and governments may have a better understanding of DeFi’s efficiency by assessing the related risks. The sooner you learn about DeFi, the sooner you’ll be able to put it to good use.

Disclaimer: Cryptocurrency is not a legal tender and is currently unregulated. Kindly ensure that you undertake sufficient risk assessment when trading cryptocurrencies as they are often subject to high price volatility. The information provided in this section doesn't represent any investment advice or WazirX's official position. WazirX reserves the right in its sole discretion to amend or change this blog post at any time and for any reasons without prior notice.
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Rony Roy

Rony Roy

Rony Roy is an electrical engineer who turned tech author in the Cryptocurrency space. He got block-chained in 2012 and fell in love with tech and its use-cases and has been writing his way through problems since 2016.

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